The Law and Finance hypothesis remains one of the most controversial theories in financial economics. In its original form, it argued that countries with higher legal protections for shareholders had wider share ownership dispersion and larger stock markets. The initial theory has been extended to consider not only protections against director self-dealing, but also the role that a myriad of other laws may have on financial outcomes. However, there has also been substantial criticism of this hypothesis. Much of the debate has focused almost exclusively on recent data. This is surprising, given that law has evolved over such a long period of time, and the emphasis placed on legal origins. There has been little systematic study looking at when and how company law originated, nor at how it evolved to create the modern system.

In our article titled Private Contracting, Law and Finance, we take the Law and Finance hypothesis back to its origins, by conducting an extensive analysis of shareholder protections in Victorian Britain. Instead of looking at the protections afforded by statutory corporate law, we examine the protections provided to shareholders by nearly 500 companies in their charters or articles of association. We argue that the experience of Victorian Britain was, in some respects, largely consistent with the Law and Finance hypothesis. Shareholders did enjoy substantial rights, there were highly developed capital markets, and there was wide dispersion of ownership.

Our paper, however, argues that it was not mandatory law that mattered. In its inaugural Companies Act in 1862, Britain codified only very basic investor protections into statutes. The approach that was taken in this era was to suggest a template of rules, but to ultimately leave the matter between the corporation and its shareholders. The protections which shareholders enjoyed were driven by firms contracting with investors, embedding protections within their articles of association. It was the existence of these protections, not their codification in statute, which mattered.

In our paper, we show that all companies offered substantially more protections than was required of them by law, and the majority voluntarily adopted as many provisions as is recommended in modern corporate law. Furthermore, we show that the focus on private contracting allowed protections to evolve and it gave companies the flexibility to offer different protections. Time and experience demonstrated which provisions were useful, and which were not. During our sample period, between 1862 and 1899, we find a significant increase in shareholder protections which could be regarded as modern-day practice, and a significant reduction in archaic protections which may be regarded as being obsolete. Only when a consensus had emerged about good practice did these governance standards get encoded into company law and security-market listing requirements.

This system was sustainable because corporations had incentives to offer worthwhile protections. We find that companies with better protections enjoyed wider share ownership dispersion, demonstrating that minority investors were more willing to invest in them. This is consistent with a Darwinian process, whereby firms competed with one another for capital by choosing the optimal level of protection appropriate for their own situation.

Our findings suggest that politics did not play a critical role in developing investor protections in the United Kingdom. We find that the government during this era consciously resisted imposing any mandatory conditions, but high levels of protections were offered by companies voluntarily. The provisions which the government did suggest as a template were often ignored, and companies were able to avoid practices which would have been burdensome. In subsequent decades, the government did begin to introduce mandatory provisions, but these were generally enshrining protections which had already become common in practice. The most important role for government and the common law courts was to give the articles of association legal force, which made private contracting easier.

How could the home of the common law have very weak statutory shareholder protection law in the pre-1900 era and yet have a thriving stock market and financial system? The evidence in our paper suggests that private contracts were used to provide shareholders with adequate protection in this period. Company founders and their lawyers wrote articles of association which bound the firm to certain rules and types of behaviour. Our findings also reveal the flexibility of the system to adapt to new business environments. Indeed, our evidence supports the view that subsequent changes in company law simply reflected widespread business practice. In other words, the law slowly followed corporate practice, lending some support to the view that statutory corporate law in common law countries reflects the existing ways of doing things.